Chapter 7
Concluding Remarks
This dissertation is mainly concerned with monetary policy rules (to be pre-cise, the interest-rate rules) with time-varying behaviors, uncertainty and financial markets at both theoretical and empirical levels. Empirical evi-dence and numerical studies have been undertaken using the data of some OECD countries.
Because the IS and Phillips curves have become the baseline model of monetary policy, I have shown some empirical evidence of the two curves with both backward- and forward-looking behaviors. The estimation for several OECD countries indicates some significant relations between the inflation rate and output gap, and between the output gap and real interest rate. I have also estimated a time-varying Phillips curve with the Kalman filter and find that the response coefficient of the unemployment gap has experienced some structural changes, which imply regime changes in the economy.
Based on the empirical evidence of the IS and Phillips curves I have then discussed briefly the advantages and potential problems of the Taylor rule, and derived an interest-rate rule from a dynamic macroeconomic model with a quadratic loss function of the central bank. One observes that this interest-rate rule is akin to the simple Taylor rule in that they both are linear functions of the inflation rate and output gap. Moreover, the interest-rate rule can be greatly affected by the parameters in the macroeconomic model which consists of the IS and Phillips curves and the central bank’s
169
loss function. The empirical evidence of a time-varying Phillips curve, as a result, implies that the monetary policy rule may be time-varying rather than invariant. Therefore, I have estimated a time-varying interest-rate rule and found some empirical evidence of state-dependence. That is, the monetary policy rule is, to some extent, sensitive to the economic environment.
Employing the estimated time-varying US monetary policy rule, I have then undertaken some simulation of the IS and Phillips curves of the Euro-area, assuming that the Euro-area had followed the US monetary policy rule in the 1990s. The simulation results indicate that the monetary policy of the Euro-area was too tight in the 1990s.
What may complicate the monetary policy more than time-varying be-haviors is uncertainty. Besides parameter uncertainty in economic models, there exist still other kinds of uncertainties such as data uncertainty and shock uncertainty. Employing a State-Space model with Markov-Switching I have explored some empirical evidence of uncertainties in the IS and Phillips curves—not only parameter uncertainty but also shock uncertainty. To be precise, the parameters are time-varying and, at the same time, they may have more than one state. The shocks in the model may also have state-dependent variances. Based on this empirical evidence, I have then explored monetary policy rules under uncertainty with two approaches: (a) the adap-tive learning algorithm, and (b) robust control. While the former assumes that the central bank improves its knowledge of economic models by learning in a certain mechanism, the latter assumes that the central bank seeks an optimal policy rule from the “worst case”.
The research employing the RLS learning algorithm indicates that neither the state variables nor the control variable converge, even in a deterministic model. This is different from the conclusion of Sargent (1999) who employs an LQ framework and presumes that the central bank pretends that the time-varying parameter will remain invariant forever after it is updated. This is, in fact, inconsistent with the implication of the adaptive learning algorithm. In this dissertation, however, I have taken the time-varying parameter as an en-dogenous variable and employed a recently developed dynamic programming algorithm which can solve dynamic optimization problems with nonlinear
state equations using adaptive rather than uniform grids.
The robust control theory can, however, deal with more general uncer-tainties than the adaptive learning algorithm. The simulation with the US data suggests that uncertainty does not necessarily require caution. This is consistent with the conclusion of Gonzalez and Rodriguez (2003) and Gian-noni (2000). The former analyze the effect of the robust parameter on the optimal feedback rule with one-state and one-control model, and the latter explores the robust optimal rule with forward-looking behaviors.
While most of the literature on monetary policy rules is concerned mainly with the real economy, some researchers argue that attention should also be given to the financial markets. This problem has arisen due to the stable and low inflation rate in the developed countries in the 1990s. The financial markets have, however, experienced some significant fluctuations. Therefore, I have explored monetary policy rules with the asset prices. That is, I have set up a dynamic model with both the real economy—the inflation rate and the output gap—and the financial markets taken into account. A monetary policy rule with the asset prices has been derived. The most important dif-ference between my model and those of others, consists in the fact that I have endogenized the probability for the asset-price bubble to grow or decrease in the next period as a nonlinear function of the interest rate and the size of the asset-price bubble. Other researchers, such as Bernanke and Gertler (2000) and Smets (1997), either take such a probability as a constant or assume it to be a linear function of the policy instrument and the size of the bubble. The drawback of a linear probability function is that it is not bounded between zero and one, and it can only consider positive bubbles. The endogenization of such a probability in my model overcomes these problems. Moreover, such a probability function is found to lead to nonlinear monetary policy rules.
Another problem concerning the monetary policy rules and financial mar-kets is the zero bound on the nominal interest rate. This problem has arisen mainly because of the Liquidity Trap, deflation and financial depression in Japan in the past decade. My simulation in the presence of a zero bound on the nominal rate suggests that policy actions that aim at escaping a Liquidity Trap should not ignore the effects of the asset prices, since the depression in
the financial markets can make the recession of the real economy worse.
Finally I want to note that this dissertation is mainly concerned with monetary policy rules in a closed economy. Monetary policy rules in open economies, as mentioned in Chapter 1, can be different from those in closed economies since exchange rate may play crucial roles in monetary policy-making. Svensson (1998), for example, points out that inflation targeting with exchange rate may have several important consequences:
First, the exchange rate allows additional channels for the trans-mission of monetary policy. ... Second, as an asset price, the exchange rate is inherently a forward-looking and expectations-determined variable. This contributes to making forward-looking behavior and the role of expectations essential in monetary pol-icy. Third, some foreign disturbances will be transmitted through the exchange rate, for instance, changes in foreign inflation, for-eign interest rates and forfor-eign investors’ forfor-eign-exchange risk pre-mium ... (Svensson, 1998, p.4).
Ball (1999) finds that the monetary policy rule in an open economy is dif-ferent from that in a closed economy in two aspects: (a) the policy variable is a combination of the short-term interest rate and exchange rate, rather than the interest rate alone, and (b) the inflation rate in the Taylor rule is replaced by a combination of inflation and the lagged exchange rate. Benigno and Benigno (2000) explore different monetary policy rules under alternative exchange rate regimes and claim that a managed exchange rate is desirable.
Using an open economy model under incomplete markets, Ghironi (2000) compares the performance of alternative monetary policy rules for Canada and concludes that flexible inflation targeting dominates strict inflation tar-geting rules and the Taylor rule. More research on monetary policy rules in open economies is surely expected to be forthcoming in the future.
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